The CDS-Bond Basis: Negativity Persistence and Limits to Arbitrage

50 Pages Posted: 14 Nov 2019

See all articles by Sahar Guesmi

Sahar Guesmi

HEC Montreal

Ramzi Ben-Abdallah

University of Quebec at Montreal - School of Management - Department of Finance

Michèle Breton

HEC Montreal - Department of Management Sciences

Georges Dionne

HEC Montreal - Department of Finance

Date Written: November 4, 2019

Abstract

We reinvestigate the CDS-bond basis negativity puzzle after the financial crisis. This puzzle is defined as the unexpected persistence of the dislocation between bond and derivative credit markets. We show that the first two moments of the basis are described by three distinct Markov regimes identified with periods related to the 2008 financial crisis. We observe that the post-crisis regime differs significantly from the crisis and the pre-crisis regimes. We then explore the cross-sectional variation of the CDS-bond basis in each regime. Using a model with several limit-to-arbitrage factors, we validate that the negative basis can be explained by liquidity risk in both the bond and CDS markets, together with counterparty risk, collateral quality, and funding constraints. Finally, we propose a model to empirically affirm that the basis negativity persistence during the post-crisis period is mainly related to a significant decrease in basis arbitrage activity, which is partly explained by the post-crisis regulatory reforms.

Keywords: CDS-bond basis, Markov regime, arbitrage, liquidity, financial crisis, Basel regulation, Dodd-Frank Act

JEL Classification: G12, G13, G14, G18, G28

Suggested Citation

Guesmi, Sahar and Ben-Abdallah, Ramzi and Breton, Michèle and Dionne, Georges, The CDS-Bond Basis: Negativity Persistence and Limits to Arbitrage (November 4, 2019). Available at SSRN: https://ssrn.com/abstract=3481470 or http://dx.doi.org/10.2139/ssrn.3481470

Sahar Guesmi

HEC Montreal ( email )

3000, Chemin de la Côte-Sainte-Catherine
Montreal, Quebec H2X 2L3
Canada

Ramzi Ben-Abdallah

University of Quebec at Montreal - School of Management - Department of Finance ( email )

315 Sainte-Catherine East
Montreal, Quebec H2X 3X2
Canada
(514) 987-3000 # 2821 (Phone)
(514) 987-0422 (Fax)

Michèle Breton

HEC Montreal - Department of Management Sciences ( email )

Montreal, Quebec H3T 2A7
Canada
514-340-6490 (Phone)
514-340-5634 (Fax)

Georges Dionne (Contact Author)

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada
514-340-6596 (Phone)
514-340-5019 (Fax)

HOME PAGE: http://www.hec.ca/gestiondesrisques/

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